One year ago, steadily climbing interest rates led 85% of economists in one poll to predict a recession in 2023. In March, Fed Chairman Jerome Powell expressed the fear that bringing down the rate of inflation would cost millions of jobs. While short-term rates did continue to climb into mid-summer, the economy continued to grow around 2% in real terms. Unemployment stayed well below 4% all year while long-term inflation expectations remained muted. As a result, the 10-year Treasury yield, which gyrated wildly throughout the year, finished about where it started, near 3.9%. The unexpected was a consumer still willing to spend without fear of recession and a desire to enjoy services deprived during the pandemic.
Consequently, 2023 was a surprisingly good year for stocks. Not only was a recession avoided but investors shrugged off multiyear-high interest rates, ongoing fighting in Ukraine and the Middle East and early election-cycle uncertainty. The S&P 500 stock index ended the year up 24% and within a fraction of its all-time high in January 2022. This was the first time since 2012 that the index failed to close at a record high at least once during the year. It’s important to point out that these returns are due mainly to the performance of a very small group of tech stocks that people are calling the “Magnificent Seven”, based largely on the potential for transformative benefits from generative artificial intelligence (AI). Composed of Apple, Alphabet (Google), Amazon, Meta Platforms (Facebook), Microsoft, Nvidia and Tesla, the group contributed roughly 60% to the S&P 500’s gains in 2023. A better indication of the typical stock’s performance in 2023 is that of the Equal-Weighted S&P 500 which rose 12%. Only three sectors and 28% of stocks (the lowest level since at least 1980) performed better than the S&P 500, while three sectors and 176 stocks in the S&P 500 had negative price returns for the year.
The Fed has finished raising short-term interest rates. The question is when will it start cutting and by how much? Historically, the Fed’s first rate cuts are not bullish for stocks, and the median length of a Fed pause prior to a recession start is 6.5 months.
Long-term interest rates will reflect a combination of inflation and growth expectations. Inflation expectations will likely continue to decline absent a spike in oil prices from a supply shock. At the same time, growth in 2024 is likely to moderate from a surprisingly robust 2023. Excess savings from the huge government Covid payouts are largely dissipated, putting a damper on consumer spending. The Index of Leading Economic Indicators has fallen for 20 consecutive months. It's worth noting that employment is a lagging indicator. Given the global macro backdrop which includes China’s economy in a sharp slowdown and Europe near recession, the odds of recession in the U.S. are rising. Interestingly, most economists now think a “soft landing” (i.e. an economic slowdown but no recession) is the most likely outcome in 2024.
Profits will be a key determinant and differentiator of stock prices. AI will enhance both productivity and the consumer experience. But it also will be expensive, requiring massive spending for computing capacity, semiconductors, and adequate electrical grid capacity. Away from AI, however, declining growth rates and slower inflation mean corporate top line growth will moderate, putting pressure on profit margins. The current consensus of 11% earnings growth for the S&P 500 seems overly optimistic.
Of course, 2024 is an election year. With the country bitterly divided, half of the electorate will be unhappy with the outcome. Historically, in presidential election years, the S&P 500 has finished up three-quarters of the time—by an average of 7.5%. Typically, you get some volatility around the election and then a relief rally through the end of the year. Importantly, most of the Trump tax cuts are going to expire in 2025, no matter who wins the White House. If there is gridlock due to a divided government, those tax cuts will likely not be extended as they are now.
A slower or even recessionary economic growth environment doesn’t mean there won’t be compelling investment opportunities in the equity market. Companies flourish in part because of an economic tailwind but more so due to the actions of their own managements and their employees who work diligently every day. Thoughtful investors understand that investment success is not defined by a year or two of high gains but years of consistent returns and managing risk. We are confident that our disciplined fundamental research approach will be beneficial in identifying good opportunities in a market that’s likely to be characterized by widely disparate outcomes.
All of us at LVM extend our very best wishes for a happy, healthy and prosperous 2024!